26. Business finance

Question 1

Why business activity requires finance?

Answer 1

• Setting up a business will require cash injections from the owner(s) to purchase essential capital equipment and possibly premises
• All businesses will have a need to finance their working capital - the day to day finance needed to pay bills and expenses and to build up stocks
• Expansion requires further finance to increase the capital assets and often they require higher working capital needs
• A change in the environment such as economic recession, new competition leading to decline in sales result in the need for cash
• Finance is also being used to pay for research and development into new products or marketing strategies and campaigns to enter overseas marker

Question 2

Why different needs for finance might mean different sources are appropriate?

Answer 2

Some of the situations will need investment for many years while other will need short term funding. Some might be medium term finance - between one and five years. Thus, not one source of finance is likely to be suitable in all cases

Question 3

Define start-up capital

Answer 3

Investment required by an entrepreneur or business person to build up their business e.g. expenditure on capital equipment

Question 4

Define working capital

Answer 4

The capital needed to pay for raw materials, day-to-day running costs and credit offered to customers Working capital = current assets - current liabilities

Question 5

Define capital expenditure

Answer 5

Involves the purchase of assets that are expected to last for more than one year, such as building and machinery

Question 6

Define revenue expenditure

Answer 6

Is spending on all costs and assets other than fixed assets and includes wages and salaries and materials bought for stock

Question 7

Define liquidity

Answer 7

The ability of a firm to be able to pay its short-term debts

Question 8

Define liquidation

Answer 8

When a firm ceases trading and its assets are sold for cash to pay suppliers and other creditors

Question 9

Significance of working capital

Answer 9

• The lifeblood of a business
• Finance is needed to pay for everyday expenses such as the payment of wages and buying of stock
• Without sufficient working capital a business will be illiquid - unable to pay its short term debts => bank loan or liquidation

Question 10

How much working capital is needed?

Answer 10

Too low => illiquid Too high is a disadvantage, the opportunity cost of too much capital tied up in inventories, accounts receivable and idle cash is the return that money could earn elsewhere in the business. e.g. invested in fixed assets

Question 11

Working capital cycle

Answer 11

• Production -> sell on credit -> cash -> materials and stock (cycle repeats and goes in circle) - How much working capital is needed depends on the length of the working capital cycle - The longer the time period, the greater the working capital needs - To give more credit than is received is to increase the need for working capital - To receive more credit than is given is to reduce the need for working capital

Question 12

What are the internal sources of finance?

Answer 12

• Profits retained in the business
• Sale of assets
• Reductions in working capital

Question 13

What are the external sources of finance?

Answer 13

• Long term: share issue, debentures, long term loan, grants
• Medium term: leasing, hire purchase, medium-term loan
• Short term: bank overdraft, bank loan, creditors, factoring

Question 14

Differences between short term and long term finance

Answer 14

• Short term finance: up to a period of a year, increase inventory orders, payrolls and daily supplies
• Long term finance: acquire new equipment, for R&D, ash flow enhancement and company expansion

Question 15

Retained profits

Answer 15

After the profits has been taken in tax by the government and has been paid out to the shareholders as dividens, retained profits are remained as a source of finance for future activities

Question 16

Sale of assets

Answer 16

Some of assets that are no longer fully employed could be sold to raise cash. In addition, some businesses will sell assets they the still intend to use but lease them

Question 17

Reductions in working capital

Answer 17

When companies reduce assets - by reducing their working capital - capital is released and acts as a source of finance for other uses

Question 18

Bank overdrafts

Answer 18

• Definition: bank agrees to a business borrowing up to an agreed limit as and when required
• Most flexible source of finance
• Bank allows business to overdraw on its account. This overdrawn amount should always be agreed in advance and always has a limit
• Businesses able to increase the overdraft over short periods of time
• High interest is charged
• Bank is able to call in the overdraft and forces business to pay it back

Question 19

Trade credit

Answer 19

By delaying the payment of bills for goods and services received, the business is actually obtaining finance. Its suppliers or creditors are providing goods and services without receiving immediate payment => similar to lending money

Question 20

Debt factoring

Answer 20

• Definition: selling of claims over debtors to a debt factor in exchange for immediate liquidity - only a proportion of the value of debts will be received as cash
• Immediate cash is obtained but not for the full amount of debt because the debt factoring company charges an amount of money for their service => to make profit

Question 21

Leasing

Answer 21

• Definition: obtaining the use of equipment or vehicles and paying a rental or leasing charge over a fixed period
• Avoids the need for business to raise long term capital to buy the asset
• Avoids risk of using unreliable or inefficient equipment
• Improve short term cash flow position of a company

Question 22

Hire purchasing

Answer 22

• Definition: an asset is sold to a company that agrees to pay fixed repayments over an agreed time period - the asset belongs to the company
• Improve short term cash flow position
• Avoids risk of using unreliable or inefficient equipment
• Avoids making a large initial cash payment to buy the asset

Question 23

Long term loans

Answer 23

• Loans that do not have to be repaid for at least one year
• Business has to provide security or collateral for the loan; this means the right to sell an asset to the bank if the company is unable to repay the debt

Question 24

Equity finance

Answer 24

• Definition: permanent finance raised by companies through the sales of shares
• Can be done by 2 methods: public issue by prospectus and arranging a placing of shares with institutional investors without the expense of a full public issue
• Prospectus: advertise the company and its share sale to the public, has to be prepared and issued, often guaranteed by a merchant bank (which charges for its service) => expensive
• Institutional investors:

Question 25

Define rights issue

Answer 25

Existing shareholders are given the right to buy additional shares at a discounted price

Question 26

Long term bonds or debentures

Answer 26

• Definition: bonds issued by companies to raise debt finance often with a fixed rate of interest

Question 27

Grants

Answer 27

• Definition: Bounty, contribution, gift, or subsidy bestowed by a government or other organization for specified purposes to an eligible recipient

Question 28

Venture capital

Answer 28

• Definition: risk capital invested in business start ups or expanding small businesses that have good profit potential but do not find it easy to gain finance from other resources

Question 29

Micro finance

Answer 29

.

Question 30

Factors influencing finance choice

Answer 30

• cost
• flexibility
• need to retain control
• the use to which it is put
• level of existing debt

Question 31

Why is cost significant?

Answer 31

• Obtaining finance is never free - might have an opportunity cost
• Loans and overdrafts may become very expensive during a period of rising interest ates
• Floatation can cost millions in fees and promotions of the share sale

Question 32

Why is flexibility important?

Answer 32

Applies especially for firms that have seasonal patterns of sales and cash receipts

Question 33

Why is the legal structure and need to retain control important?

Answer 33

Share issues can only be used by limited companies and only plc can sell shares to the public => current owners lose control unless rights issue is used

Question 34

Why is the use to which it is put important?

Answer 34

• Permanent capital may be needed for long term business expansion
• Short term finance would be advisable to finance a short term need to increase stocks or pay creditors

Question 35

Why is level of existing debt important?

Answer 35

The higher the existing debts of a business, the greater the risk of lending more. Might lead to loss of assets or higher interests